1June 2008

Decentralization, Provincial Tax

Autonomy and Equalization in Canada

2

Overview

What are the interrelationships/connections

between the high degree of tax

decentralization and provincial tax autonomy

in Canada, on the one hand, and Canada’s

Equalization program, on the other?

• Decentralization

• Tax AutonomyEqualization

3

Three Themes

The origins of Canada’s Equalization program are

closely tied to tax decentralization. The program has

helped make decentralization acceptable to provinces

with lower fiscal capacities.

The degree to which fiscal disparities can be equalized

in Canada is limited (constrained) by the high degree

of tax decentralization

The substantial variation among provincial tax

systems in Canada poses significant challenges in

terms of fiscal capacity measurement and the

determination of equalization payments

4

The Canadian Constitution allows for a high

degree of decentralization

The Constitution Act gives provinces

• primary responsibility for (what have turned out to be)

some of the most important expenditure areas: social

welfare, health care, education, etc.

• access to, and full discretion over, most major revenue

sources: personal and corporate income taxes, sales

taxes, estate taxes, natural resource taxes and

royalties, property taxes, etc.

5

A defining feature of the evolution of the Canadian

federation in the postwar period is a gradual by persistent

decentralization of fiscal responsibilities

Federal and Provincial-Local Shares of Government

Expenditure, Excluding Inter-Governmental Transfers

20%

30%

40%

50%

60%

70%

80%

1933

1936

1939

1942

1945

1948

1951

1954

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

Sh

are

of

To

tal

Provincial-Local

Federal

6

From its beginnings in 1957, the Equalization program has

helped to make tax-decentralization acceptable to revenue-

poor provinces

The Equalization program was launched in 1957

in conjunction with a major tax decentralization

for personal and corporate income taxes and

inheritance taxes.

Without the program, the devolution of tax shares

to provinces would not have been acceptable to

revenue-poor provinces.

As tax decentralization progressed, the

Equalization program has continued to play a

central role in making decentralization acceptable

to provinces with lower fiscal capacities.

7

Tax Decentralization

Canada is one of the most tax-decentralized federations in

the world.

Tax Revenue of State and Local Government Sub-Sectors as

Percentage of Total Tax Revenue, 2005

2.1%

14.8%

8.5%

24.0%21.4% 20.1%

25.1%

38.4%

3.0%

9.4%

5.0%7.8%

14.1%

15.6%

8.4%

1.1%

0%

10%

20%

30%

40%

50%

Mex

ico

Austra

lia

Austri

a

Belgi

um

Ger

man

y

Uni

ted

State

s

Switz

erla

nd

Can

ada

Perc

en

t o

f T

ota

l

Local Government

State/Province/LänderGovernment

Source: OECD Revenue

Statistics, 1965 - 2006

State/Province/Länder

and Local government

revenues are shown as a

percentage of total tax

revenues, including

revenues of federal

government, social

security funds (separate

government sub-sector)

and supranational

governments.

29.0%

40.7%

34.2%

17.8%

29.2%

17.9%

3.2%

46.8%

8

Provinces and municipalities together raise significantly

more revenue than the federal government

Federal, Provincial, and Local Government Shares of Own-Source

Revenue: 1961 to 2006

42.5%

46.2%

11.2%

0%

10%

20%

30%

40%

50%

60%

70%

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

Sh

are

of

To

tal

Ow

n-S

ou

rce

Re

ve

nu

e

Federal

Provincial

Local

9

Tax Autonomy

Canadian provinces have the highest degree of tax

autonomy among state-level sub-central governments

in the OECD federations

Tax-Autonomy of State/Province/Länder Governments, 2002

8683

4636

10

1110

7

5464

9098

0%

20%

40%

60%

80%

100%

Ger

man

y

Austri

a

Austra

lia

Belgi

um

Switz

erla

nd

Can

ada

Perc

en

t o

f S

tate

Reven

ue

Full discretion on rates andreliefs

Rates and reliefs set bycentral government

Tax sharing arrangement

Full or partial discretion onrates only

Other

Source: “Fiscal Autonomy of Sub-

Central Governments”, OECD

Network on Fiscal Relations Across

Levels of Government, 2006.

10

Tax Differences Among Provinces

Canadian provinces have access to virtually all tax fields, including some not available to the federal government.

Provinces have full discretion over the choice of tax bases and tax rates, although they are able to freely participate in federal-provincial income and sales tax harmonization agreements.

The result is a set of provincial tax regimes with some commonalities but which generally differ significantly among one another.

11

Even for income taxes there are growing

differences among provinces

Traditionally, the greatest degree of

commonality has been in the area of personal

and corporate income taxes.

But even here, there is a trend towards

greater differences.

New tax collection arrangements with the

federal government give provinces the

flexibility to choose their own rate structures

and their own tax credits for personal income

taxes.

12

Personal and corporate income tax regimes

differ significantly

There are differences in statutory rate

structures, overall effective tax rates, and tax

reliefs to individuals and firms.

Statutory Tax

Rates

Average

Effective Rate

NL 10.57% to 18.02% 8.98%

PEI 9.80% to 16.70% 7.41%

NS 8.79% to 17.50% 8.03%

NB 9.68% to 17.84% 7.63%

QUE 13.21% to 19.82% 9.61% <-- High

ONT 6.05% to 11.16% 7.91%

MAN 10.90% to 17.40% 8.25%

SASK 11.00% to 15.00% 7.43%

ALTA 10.0% 6.59%

BC 6.05%-14.70% 5.48% <-- Low

Personal Income Tax: 2006

Average

Effective Rate

NL 9.9%

PEI 14.0% <-- High

NS 10.9%

NB 11.8%

QUE 7.4% <-- Low

ONT 10.9%

MAN 9.7%

SASK 11.7%

ALTA 7.5%

BC 7.4%

Corporate Income Tax: 2006

13

For other taxes, differences are generally

more substantial than for income taxes

General sales tax systems differ greatly across provinces.

There are important differences in

• payroll taxes,

• product specific consumptions taxes, and

• revenues derived from government business enterprises (electricity, alcohol, lotteries, casinos, etc.)

For property taxes there is a more or less common base, but rates differ by municipality and property use (residential, commercial, farm, etc.)

Resource taxes, which are a very important source of revenue for some provinces, are completely unharmonized.

14

Pre-Equalization Fiscal Disparities

Compared to some other federations, there are large pre-

equalization fiscal disparities among regions in Canada.

Per Capita Fiscal Capacity, 2008-09

$7,176

$4,909

$5,881

$5,140

$6,196

$7,365

$5,646

$8,002

$13,660

$7,481

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

NL PE NS NB QC ON MB SK AB BC

Do

llars

15

Disparities in Fiscal Capacity for Natural

Resource Revenues

Natural resource are a particularly important source of

fiscal disparities in Canada

Per Capita Resource Fiscal Capacity, 2008-09

$2,070

$2

$359

$87 $96 $50$199

$2,030

$3,868

$692

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

NL PE NS NB QC ON MB SK AB BC

Do

llars

Average

16

Because fiscal disparities are large, there is

a high “need” for equalization.

Fiscal Capacity Index

60

80

100

120

140

160

180

1990

-91

1991

-92

1992

-93

1993

-94

1994

-95

1995

-96

1996

-97

1997

-98

1998

-99

1999

-00

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

2006

-07

2007

-08

2008

-09

Nati

on

al

Ave

rag

e =

100

Quebec

Ontario

Alberta

Resource-Rich Provinces (AL,SK, BC, NL)

Non-Resource-Rich Provinces(ON, QC, MB, PEI, NS, NB)

17

The Canadian Equalization program reduces

horizontal disparities only partially

-4,000 -2,000 0 2,000 4,000 6,000

Prince Edward Island

New Brunswick

Manitoba

Nova Scotia

Quebec

Newfoundland

Ontario

Saskatchewan

British Columbia

Alberta

-2,000 0 2,000 4,000 6,000

Prince Edward Island

New Brunswick

Manitoba

Nova Scotia

Quebec

Newfoundland

Ontario

Saskatchewan

British Columbia

Alberta

Pre-equalization Post-equalization

Large disparities remain after equalization, notably

between Alberta and the other nine provinces.

18

Equalization

The principle of equalization is enshrined

in the Canadian Constitution:

Parliament and the Government of Canada are

committed to the principle of making Equalization

payments to ensure that provincial governments

have sufficient revenues to provide reasonably

comparable levels of public services at

reasonably comparable levels of taxation.

(Subsection 36(2) of the Constitution Act)

19

The Equalization Program

This graph shows the basic mechanics of the program

as it has operated throughout most of its history

Equalization: Illustrative Example of Basic Mechanics

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

PE NB MB NS NL QC SK ON BC AB

Do

lla

rs P

er

Ca

pit

a

Standard

Equalization

Own-Source Fiscal Capacity

20

Increasing decentralization has led to a

lowering of the standard

The Equalization standard has changed several

times throughout the history of the program.

• Examples: Top-2 province standard in 1957, 10-province

standard in 1962, 5-province standard in 1981.

With increasing decentralization, the trend has

generally been towards a lowering of the

standard.

Increasing decentralization has resulted in higher

fiscal disparities, making it more difficult (costly)

for the federal government to equalize to a given

standard.

21

Natural resource revenues have played a key role

in the history of Equalization

Relative Per Capita Fiscal Capacity, 1972-73 to 2007-08

50

100

150

200

250

1972-73 1977-78 1982-83 1987-88 1992-93 1997-98 2002-03 2007-08

Alberta

Resource-rich

provinces

Quebec

Ontario

Resource-poor provinces

22

Equalization payments for 2008-09 total

$13.6 billion dollars

Equalization Payments ($ millions)

2004-05 2005-06 2006-07 2007-08 2008-09

Newfoundland and Labrador

(NL) 762 861 687 477 158

Prince Edward Island (PEI) 277 277 291 294 322

Nova Scotia (NS) 1,313 1,344 1,386 1,465 1,465

New Brunswick (NB) 1,326 1,348 1,451 1,477 1,584

Quebec (QC) 4,155 4,798 5,539 7,160 8,028

Ontario (ON)

Manitoba (MB) 1,607 1,601 1,709 1,826 2,063

Saskatchewan (SK) 772 89 13 226

Alberta (AB)

British Columbia (BC) 682 590 459

Total 10,894 10,907 11,535 12,925 13,620

23

Fiscal capacities are equalized, but provinces are left

free to choose actual levels of taxation and expenditure

The Equalization system is only meant to provide

provinces with the capacity to provide reasonably

comparable levels of services at reasonably

comparable tax rates.

But provinces are free to choose any actual level of

taxation and any actual level of expenditure they want.

Given their high degree of tax and expenditure

autonomy, provinces in fact make significantly different

choices.

24

Provinces choose to impose substantially

different tax rates…

Provincial-Local Fiscal Capacity, Own-Source Revenue, and Tax Effort, 2006-07

Fiscal Capacity Per

Capita

Own-Source Revenue Per

Capita Tax Effort

NL $6,250 $6,728 107.6%

PE $4,864 $5,162 106.1%

NS $5,637 $5,800 102.9%

NB $5,152 $5,282 102.5%

QC $6,117 $7,079 115.7%

ON $7,273 $7,310 100.5%

MB $5,519 $5,982 108.4%

SK $7,681 $8,863 115.4%

AB $12,765 $9,833 77.0%

BC $7,121 $7,073 99.3%

25

… and to provide significantly different

levels of government services.

Total Expenditures of Provincial-Local Government Sector, 2006-07

Provincial-Local Government Expenditure

($ Per Capita)

Percent of Average

NL $11,051 103.7%

PE $10,002 93.8%

NS $10,564 99.1%

NB $10,045 94.2%

QC $11,931 111.9%

ON $10,107 94.8%

MB $10,842 101.7%

SK $11,625 109.1%

AB $10,751 100.9%

BC $9,664 90.7%

26

Other major transfers to provinces and territories also

have important equalizing effects

Canada Health

Transfer

EqualizationWait Times Reduction

Transfer

Canada Social

Transfer

Territorial

Formula

Financing

$12.9 billion

$21.3 billion

$9.5 billion

$1.2 billion $2.2 billion

Major Transfers, 2007-08

27

The CHT and CST are equalizing because federal taxpayers

in richer provinces contribute more to the funding of these

transfers

Net Redistribution of Revenue Through CST and CHT, 2005-06

($ million)

Gross

transfer

Origin of federal revenue to fund

transfer

Net transfer

NL 488 -341 148

PEI 131 -100 31

NS 889 -658 230

NB 713 -487 227

QC 7,205 -5,789 1,416

ON 10,903 -12,082 -1,179

MB 1,114 -814 300

SK 988 -765 222

AB 2,166 -4,023 -1,857

BC 4,037 -3,575 462

Total 28,634 -28,634 0

28

Equalization and Tax-Autonomy: Measuring

Tax Disparities

The high degree of tax autonomy of Canadian provinces poses important measurement challenges for equalization.

Because of the high degree of tax autonomy of provinces, the use of actual revenues is not possible in Canada.

The approach that has been used in Canada since 1967 to measure the relative fiscal capacities of provinces is the representative tax system (RTS) approach.

29

Representative Tax System

The RTS approach determines fiscal capacity by measuring the per capita revenue provinces could(potentially) raise if they implemented a typical (“representative”) provincial tax system.

Fiscal capacity is measured separately for each provincial and local government revenue source.

The fiscal capacity of each province for each revenue source is measured by applying the national average effective tax rate to the representative tax base for each provinces.

A key challenge is to define a common “representative” base for each revenue source, given that the actual tax bases of the 10 provinces may differ greatly.

30

Measuring Fiscal Capacity for Natural

Resource Revenues

Measuring fiscal capacity for resource revenues has always presented a special challenge for Equalization.

The key reason for this is that provinces generate natural resource revenues through taxes on the volume or value of the resources produced.

But while tax rates are directly applied to statutory volume or value bases, provinces are actually (though indirectly) taxing economic rent.

31

Natural Resource Bases

Volume and value bases were used in the past for Equalization purposes – as well as one economic rent base (for revenues from mining).

On the advice of an expert panel, the government moved to the use of actual revenues for natural resources in 2007. The inclusion rate for natural resource revenues was reduced to 50%.

32

Federal-Provincial Fiscal Arrangements

Issues for Canada

1. Size of the Equalization program

2. Treatment of natural resource revenues in Equalization

3. Sharing of Alberta’s resource rents

4. Transfer of further tax room

5. Use of the federal spending power

6. Tax harmonization

7. Reassignment of tax fields

33

Federal-Provincial Fiscal Arrangements

Issues (cont’d)

1. Size of the Equalization program

2. Treatment of natural resource revenues in Equalization

3. Sharing of Alberta’s resource rents

4. Transfer of further tax room

5. Use of the federal spending power

6. Tax harmonization

7. Reassignment of tax fields

8. Use of the federal spending power